Diversified Companies Shrink 'Conglomerate Discount'

Large, multinational conglomerates considering a crash diet may want to think twice if they wish to reward shareholders: the argument that smaller is better is a little less persuasive these days.

Stock markets traditionally discount conglomerates, especially in North America, and reward moves that shift a company toward a more narrow focus. Many investors figure smaller companies can be nimbler, more transparent, easier to compare to peers, and more likely to be takeover targets.

Yet big conglomerates are regaining favor, as some researchers and long-term shareholders argue that the case for diversification is stronger after the 2007-2009 financial crisis.

The so-called 'conglomerate discount' — the value difference between companies with three or more divisions that serve different markets, and more focused companies — shrank among some 16,000 companies studied by the Boston Consulting Group (BCG).

In North America, the discount shrank to 7.2 percent, from 10 percent, between 2005 and 2009. The change was even more dramatic in Western Europe, narrowing to a 6 percent discount from 11 percent, while in Asia conglomerates now command a market premium, according to the BCG analysis.

"The very diversification that the media and investment analysts have criticized for so long is now being recognized as beneficial," the BCG report concludes.

The financial crisis drove the shift in perception, making diversified companies seem less risky. Corporate governance has improved and such firms now command higher credit scores and lower costs for protecting against default. When markets are in turmoil, bigger is better.

The conglomerate business model makes sense, said Rob McIver, co-manager of the Jensen Quality Growth Fund, a concentrated, $4 billion portfolio that typically holds shares for years. The fund is a long-term holder of United Technologies Corp., Emerson Electric Co. and snack and drinks giant PepsiCo.

"In Pepsi's case, (as with) Emerson and UTX, we do believe there's an awful lot of synergies that can be gathered," McIver said, citing United Tech's track record of acquisitions. "The sum of the parts is really much more powerful than the individual elements."

Over a decade, diversified companies' total shareholder return averaged 6.1 percent a year, compared to 5.8 percent for focused companies.

The outperformance was slight, but diversified companies achieved it with less volatility, BCG argued in the recent study.

One of the reasons for the shrinking conglomerate discount is that the big names proved in the downturn they can generate cash when outside financing is scarce.

3M Co., for example, could finance acquisitions during the credit crunch because its diversity gave it a better risk profile. The maker of everything from iPad components to Scotch tape used its advantage from diversification to invest in acquisitions when prices were relatively low. In late 2008, at the peak of the crisis, 3M completed nine deals in four months. Its stock price later rebounded faster than its peers.

SIZE ADVANTAGE

To be sure, a crash diet can swiftly raise a company's value.

Shares of companies as varied as Tyco International, SPX Corp., energy company ConocoPhillips, McGraw-Hill, and Expedia, all popped on the days when they announced split-ups or major divestitures. Tyco is up 18 percent, outperforming the wider market, since announcing a three-way split in September.

Others who opted to slim down in recent years include consumer companies Kraft Foods Inc. and Ralcorp Holdings. ITT Corp. was, until last year, part of a much larger conglomerate.

SPX is up 14 percent since agreeing last month to sell its auto tools business to focus on flow technology for food and energy markets.

SPX shareholders "have supported the movement of the company towards more of a pure-play flow business," SPX Chief Executive Chris Kearney said in an interview. "We've seen (Tyco and ITT) head down that path, too."

The stock boost from a divestiture or a break-up is a short-term effect, said Dieter Heuskel, one of the authors of the BCG study.

"For shareholders who want to be in a stock for that uplift, it's fine," he said. "(But) if you think about corporations as going concerns, then this environment is more in favor of conglomerates than in the past."

Conglomerates have a financial edge that allows them to invest in new products or acquisitions, and brace for market shocks. Many manufacturers are sticking with a diversified approach, Heuskel said, citing General Electric Co., Emerson, United Tech, and Siemens.

Ingersoll Rand Plc CEO Mike Lamach rejects calls to hive off pieces of the company. The heating and cooling systems maker has cut costs, streamlined manufacturing, and cut debt in anticipation of an eventual revival in its key housing and commercial construction markets.

"I'd like to see some tailwind and understand the value of the company at that point in time rather than thinking about something prematurely," Lamach told a Barclays investor conference last week.

"There's nothing transformational in the cards for us in the short run. Our focus is on integrating and operating the company."